Fed governor acknowledges whiff on subprime crisis

Dow Jones/AP

Published 6:30 am, Thursday, January 17, 2008

NEW YORK -- Federal Reserve Bank of Cleveland President Sandra Pianalto today offered a rare mea culpa from the Fed regarding the U.S. subprime mortgage sector meltdown and its detrimental effects on the overall U.S. economy.

"What we missed was knowing how all these activities would end up in the perfect storm environment," Pianalto said in response to a question from the audience after giving a speech in Cleveland.

It's "always difficult" to know when housing or other bubbles are developing, she said, referring to rapid increases in valuations of assets until they reach unsustainable levels

"You can look backward and see bubbles, but in the middle of the activity" it's difficult, she said.

The Fed is working to prevent problems such as the subprime debacle from happening again, she said. For example, the Fed is making efforts to educate consumers about the risks associated with home loans that are often complicated financial transactions, she said.

But Pianalto said neither she, the Fed as whole, nor anyone else "is very good at projecting economic activity in the future."

She said her forecasts on the economy have changed since November amid new signs of a worsening housing sector and weaker employment figures.

The Fed's primary tool used to achieve its two main objectives — price stability and maximum employment — is through monetary policy such as interest rate adjustments.

But monetary policy, Pianalto said, "is broad based ... it can't target specific industries," such as the housing sector or volatile stock markets, without also affecting other areas.

The Fed official, who is a voting member of rate-setting Federal Open Market Committee, also fielded a question about the weaker dollar and its role in the worsening U.S. economy.

She said the economy has seen an "orderly" decline since 2002 as the United States increased its imports compared with its exports.

On one hand, the weaker dollar boosts U.S. exports, which is a positive for the economy, she said. But it also increases the prices for imports, which she said could pressure inflation.

Pianalto also expressed concern that the manufacturing sector could be hurt by a weaker dollar. While it helps the sector by making export products cheaper and thus more competitive, it also increases the cost of imported products, which often make up a big part of the production process, she said.

"So it's not clear" whether manufacturers benefit from the weaker dollar, she said.

Finally, Pianalto said she was not troubled by the huge amounts of foreign capital going into big U.S. banks that have been stung by the subprime crisis. Foreign interest in U.S. financial institutions shows confidence in the long-term prospects for the U.S. economy, she said.